Microsoft: Goldman Cuts Surface Price, Margin Forecast

By Tiernan Ray

Microsoft (MSFT) shares today are down 66 cents, or 1.8%, at $37.18, following a ratings cut by Merrill Lynch‘s Kash Rangan, who dropped the stock to Underperform from Neutral, and from Goldman Sach‘s Heather Bellini, who reiterated a Sell rating and a $28 price target.

Bellini cut her EPS estimates for this year ever-so-slightly, to reflect both a lower outlook for personal computer shipments, but also diminished profit prospects for Microsoft’s Surface tablet computer.

For PCs, Bellini writes that the Goldman analyst team cut its outlook for PC shipments for the December-ending quarter, Microsoft’s fiscal Q2, to 78.7 million units shipped by the industry worldwide, down from a prior projection of 79.8 million units, a decline of 10% from the same quarter last year.

The firm also lowered its estimate for the 12 months of Microsoft’s fiscal year ending next June to 303 million PC units shipped, down 7.6% from the prior period, and worse than the prior 6.6% drop that was estimated.

Meanwhile, tablet shipments may reach 245 million in the same 12-month period, growth of 20%, higher than a prior 18% estimate. And Microsoft’s Surface may have 9.6 million Surface shipments, slightly better than her 9.3-million prior estimate.

However, Bellini cuts her pricing and margin assumptions for Surface:

We have adjusted our Surface revenue forecast given new pricingdynamics and our revised views on units and mix. Microsoft is nowselling its 64GB Surface RT without a cover for $399 (vs. prior list of $449) and the same SKU with a cover for $449 (vs. prior list of $499). Accordingly, our Surface revenue estimate for F2Q14 is now $259mn assuming the company sells roughly 400K devices (100K Surface RT, 200K Surface Pro 2, and 100K Surface RT 2) versus our prior forecast of $268mn based on roughly 350K units (50K Surface Pro, 200K Surface Pro 2, and 100K Surface RT 2 units). In addition, we have updated our view on Surface gross margin given disclosure in the F1Q14 10-Q: “D&C Hardware cost of revenue increased, primarily due to $645 million higher Surface cost of revenue.” Given Surface revenue of $400mn in the quarter, this implies gross margins were negative 55% in the quarter vs. our assumption of 5%. Accordingly, we have adjusted our view on Surface gross margin for FY14 and FY15 to -21% / -6% from mid-single digits prior given our view on mix and our assumption that it takes Microsoft several quarters to work down inventory and improve fixed cost absorption.

The upshot of that is minimal, with Bellini maintaining an 83.3 billion revenue estimate for fiscal ’14, while cutting her EPS estimate just a penny, to $2.53.

Regardless of the numbers, Bellini thinks Microsoft is still too tied to PCs:

We continue to believe that Microsoft is fundamentally tied to the PC market, which is facing significant structural challenges due to the popularity of smartphones and tablets, where Microsoft has been a laggard. And, as Microsoft has been a share loser in consumer compute, we believe the company’s long-term fate will be predicated on whether Microsoft can successfully drive adoption of its new mobility offerings while also trying to slow the rate of decline in PCs. While Microsoft’s enterprise-related businesses give the company a somewhat stable near-term ballast (longer-term prospects are more questionable due to “the consumerization of IT” and the BYOD trend in the workplace) and cloud services such as Azure could be promising businesses over time, we believe revenue and earnings are likely biased lower given top-line and profit tied to compute combined with significant business investment.

About Tech Trader Daily

Tech Trader Daily is a blog on technology investing written by Barron’s veteran Tiernan Ray. The blog provides news, analysis and original reporting on events important to investors in software, hardware, the Internet, telecommunications and related fields. Comments and tips can be sent to: techtraderdaily@barrons.com.